If I ask my parents, which is best, FD or mutual fund, their obvious answer will be FD. They come from an era when FD was a popular instrument that offered both securing your savings in a bank and growing your savings at attractive rates. On the other hand, mutual funds would be risky because it's linked to the market — so there is no guarantee that you'll get your savings back.
Times have changed now. With more financial literacy among new investors, FDs have taken a back seat, while mutual funds have become a more popular investment avenue despite their risk. Let's delve further to understand each of them.
Fixed deposits (or FDs) are one of the most popular investment choices for Indians. In fact, as per RBI's research, 52% of average households' financial assets were invested in fixed deposits in banks.
On the other hand, mutual funds came into the Indian markets in the 1960s! However, they only gained popularity in the past two and a half decades. This is evident from the fact that this industry crossed a whopping ten crore folios in May 2021, as per data published by the Association of Mutual Funds in India.
Although there's been a massive pace of growth in this arena, RBI's research indicates that mutual funds account for only 7% of householding savings.
Fixed deposits provide investors with fixed interest rates over fixed tenures. These tenures stem anywhere from a period of 7 days to 10 years. Given that interest on bank fixed deposits gets compounded, interest is added to accrued interest, making it a profitable venture.
To understand this better, consider bank XYZ, which pays 6% interest on a 4-year fixed deposit; compounded annually. Should you deposit INR 100, you will have INR 106 in your account after a single year. By the end of the second year, a 6% interest will apply to the principal and its interest. This means that 6% will apply to INR 106, and this accumulation will continue for the 4-year tenure.
There's been a gradual decline in interest rates applicable to fixed deposits in the past 2.5 decades. The COVID pandemic, for instance, saw the RBI reduce interest rates aggressively, which meant banks also decreased interest rates on fixed deposits. Examine current taxation norms, and you'll notice that fixed deposit interest rates can barely beat inflation.
It is important to note that as the interest rate applicable to fixed deposits is fixed throughout the tenure of the deposit, no indexation benefit during taxation applies. It lies in contrast to mutual funds. This means there's no protection from inflation, especially with fixed deposit interest rates being particularly low.
Mutual funds are financial instruments that pool money from several investors. The cash then gets directed toward assets. These funds are supervised and managed by asset management companies. Investing in a mutual fund gives you access to a diversified portfolio of stocks or bonds. Investors can choose to invest in varied mutual fund holdings keeping their financial goals in mind.
While equity mutual funds primarily direct money toward the stock market, debt mutual funds direct money toward bond and money markets. Further, while equity mutual funds wish for capital to appreciate, debt funds focus on generating an income.
One of the key benefits of mutual funds that lands them at a top spot in the mutual fund vs fixed deposit argument is taxation. These funds serve as some of the most tax-efficient investments. While short-term capital gains (i.e., < 12 months) applicable to equity funds amount to 15%, long-term capital gains (i.e., < 12 months) applicable amount to 10%. In fact, long-term capital gains falling under INR 1 lakh are exempt from taxation.
When looking at debt funds, short-term capital gains are taxed, keeping in mind an investor’s tax slab. In contrast, long-term capital gains are taxed at 20% once indexation benefits are considered. FDs are taxed based on your tax slab. So if you fall in the highest tax bracket, you may be at a disadvantage. Further, if the interest amount exceeds ₹10,000 in a financial year, then TDS of 10% will also be deducted. This helps highlight how mutual funds are superior to fixed deposits.
The following reasons help highlight why fixed deposits have traditionally been viewed as 'safer' than mutual funds for 10-year investments.
Portfolio Diversification – Banks have diversified portfolios owing to the following reasons.
Insurance Applicable – The DICGC (Deposit Insurance and Credit Guarantee Corporation) is a RBI subsidiary that overlooks deposit insurance in cases of bank insolvency. It gives deposits a maximum insurance cover of Rs 5 lakh on their deposits across savings accounts, current accounts, Fixed Deposits and Recurring Deposits. .
Mutual funds are tethered to the following risks; however, you must understand the likelihood of them actually arising.
Credit Risk - if you choose to invest in large-cap mutual funds, your money will be directed towards investments in the country’s top 20-50 listed companies. Since the Indian economy is majorly dependent on these companies, the chances of them defaulting simultaneously and resulting in your investments losing value is slim.
Market Risk – Although mutual funds are subject to market risks, if you remain invested in them for at least ten years, the chances of your encountering negative returns are unlikely. To understand this better, consider that the past 20 years have seen an average compound annual growth rate (or CAGR) equal to 12.3%, along with a minimum CAGR equalling 5.5% across a ten-year investment period. This 5.5% figure is, in fact, almost at par with current fixed deposit rates.
The table provided below helps highlight the more crucial differences between fixed and mutual funds.
